Question

Explain the effect of an increase in government spending on the on the equilibrium output and inflation in the AD-AS model. Carefully distinguish between the short-run and the long-run equilibrium. Would this increase in government spending affect the potential output? Why/Why not? (Need a brief answer of around 300-400 words)

Answer 1

GDP = C + I + G + NX

Let the economy operate at the full employment level initially.

G is the government spending, and the above four components are components of aggregate demand. With increase in government spending aggregate demand increases. Aggregate Demand curve shifts to the right. Now, both short-run and long run supply curves remain unchanged as the capacity of the economy to produce does not change with the increase in government expenditure. Now aggregate demand exceeds the long run aggregate supply which corresponds to the full employment level. In other words total demand in the economy cannot be met by the potential output at the current price level. This is the case of excess aggregate demand, which adds inflationary pressure on the economy. Price level increases due to shortage. In the long run gradually aggregate supply increases. Long run aggregate supply shifts to the right. In the long run there is a movement of equilibrium point along the short run supply curve. Since in the long run capacity of the economy also increases, output increases. Price level dips but remains higher than the initial price level that prevailed before expenditure from the government.

Increase in government spending affects the demand side of the economy not the supply. Hence potential output remains same in the short run but adjusts to the increase in aggregate demand in the long run.

Initially output remains at Q1, and the price rises to P3, as the capacity of the potential ouput is exceeded due the higher government spending. As the potential output or the long run aggregate supply increases with time, LRAS curve shifts to the right. This causes an increase in the capacity of the economy to produce and the output increases from Q1 to Q2. Now the price level falls to P', which is higher than P1. Thus, net effect of increase in government spending in the long run, is increase in both output and price level in the economy.